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Tax Brackets vs. Tax Rates 

Investors have to choose.  Tax brackets deal with the last dollar of taxable income earned, while tax rates deal with the total taxable income earned.  Currently, the IRS has six tax brackets, each associated with a range of taxable income.  A tax bracket is a tool used to identify the correct tax you pay on the dollar amount you earn, while a tax rate is a mathematical calculation that determines the actual tax liability.  Because there are six tax brackets, the “effective tax rate” will always be lower than the tax bracket.  Think of the effective tax rate as a dollar-weighted average tax liability on all earned income (for purposes of this article we will not concern ourselves with deductions, exemptions or credits).   You do not pay the same tax rate on all income earned.  The first range of income is taxed at a lower rate than the last range of income. 

Because a tiering of income is used in the tax brackets, it is impossible for an investor to have an effective tax rate of 35 percent.  Why?  Because the first range of income is only taxed at a rate of 10 percent.  The only way an investor can have an effective tax rate of 35 percent would be if there was only one tax bracket --- 35 percent. 

When looking at tax-free municipal bonds as a potential fixed income holding, it is beneficial for the investor to use the effective tax rate to determine the actual income return, not the tax bracket associated with the range of income earned.  Investors are potentially leaving significant amounts of income on the table by assuming they are in the 35 percent tax bracket.

Let’s look at an example.  An investor has a taxable income of $400,000.  The tax bracket associated with this total income is 35 percent.  But because the investor is subject to a total of six different tax brackets, with five of these brackets lower than the 35 percent bracket, the effective tax rate is only 28 percent.  This difference of seven percent may not seem significant, but let’s look at another example.

An industry standard methodology is to compare the yield of a tax-free bond on a fully taxable equivalent basis.  In order to help “sell” the tax-free bond to an investor, a tax-free municipal bond is quoted as yielding 4.62 percent on a taxable equivalent basis, assuming a 35 percent tax rate.  If the investor’s true effective tax rate is only 28 percent, then the tax-free bond paying three percent is only paying 4.17 percent on a taxable equivalent basis.  This yield difference of 45 basis points (0.45 percent) is very important in a historically low interest rate environment.        

With an investment mandate of maximizing interest income, this differential of 45 basis points is critical to a portfolio manager.  Typically, an investor is open to owning either tax-free bonds or taxable bonds.  If the return on a taxable bond is greater than a tax-free bond, based on the actual tax liability incurred on the income earned on the bond, the portfolio manager is doing right by the investor in selecting a fully taxable bond.  But if the portfolio manager is working with inaccurate “tax rates”, the he or she is leaving money on the table that the investor should be earning.  The “lost income” incurred by using a tax bracket versus an effective tax rate is unnecessary.  Investors work too hard to leave 45 basis points of income on the table. 

Fine tuning an investor’s true tax liability can be an effective way to offset a portion of an investor’s investment management fee.  If a portfolio is heavily weighted with fixed income securities and the investor can earn an extra 45 basis points of income with proper tax information, the investor is in a win-win situation.  Let the fixed income market work for you.  Don’t let the marketing hype of a 35 percent tax bracket push you into tax-free bonds when you are, in many instances, better off owning fully taxable bonds.